Bloomberg ran a long article on the collateral transformation trade written by Brad Keogh, a reporter who has contacted us in the past and who took the matter seriously. We read the article a couple of times for what it said and what it didn’t say. Our take-away was that more questions were asked than answered. This is understandable given the uncertainty surrounding collateral transformation, but given its mix of promise and red herring dazzle, a review of the article is warranted.
The article leads in by saying that banks are helping their clients find US$2.6 trillion in missing collateral, ostensibly through the collateral transformation trade. This is a catchy lead-in but is inaccurate. First, US$2.6 trillion is a collateral shortage number that Tabb Group thought up, and fits in the middle nicely between $600 billion (IMF and others) and $5 trillion (IMF), other collateral shortage numbers we’ve seen. The real collateral shortage figure is unknown at this time and will depend on multiple factors including how much in OTC derivatives actually moves onto CCPs when all is said and done. Second, the banks would be very pleased to help their clients if they had the collateral, but all evidence suggests that they don’t. More accurately, the lead-in would have been “banks would like to help their clients…”
Darrell Duffie at Stanford played the critic: “The dealers look after their own interests, and they won’t necessarily look after the systemic risks that are associated with this,” said Darrell Duffie, a finance professor at Stanford University who has studied the derivatives and securities-lending markets. “Regulators are probably going to become aware of it once the practice gets big enough.” In fact, regulators are already aware of it (see the UK FSA’s release on liquidity guidelines from earlier this year), but so far are taking an approach that encourages communication rather than stamps down with specific rules. The UK continues with its smart Less Is More regulatory strategy. We’ll see how smart the US is when its turn comes.
Here is a helpful take from Morgan Stanley on their collateral shortage estimates: “Analysts at New York-based Morgan Stanley estimated the shift to clearinghouses would force traders to post about $481 billion of collateral, or about 0.4 percent of cleared trades. As much as 75 percent of the $462.2 trillion of interest-rate derivatives, the most common type, may be cleared once the rules take effect, up from about half currently, the analysts wrote in an Aug. 23 report. Under a worst-case scenario, traders may have to post $1.3 trillion, or 1.1 percent, they said.” And that’s just for cleared interest rate derivatives. Add Credit Default Swaps and all those uncleared FX Forwards. We’re guessing that the IMF’s $5 trillion figure is closer to the real collateral shortfall presuming that the OTC derivatives market stays at its current levels.
Finadium’s own Josh Galper weighs in as well: “Money managers, insurance companies and pension funds that use derivatives will be hardest hit by the change, said Josh Galper, managing principal of securities-lending consultant Finadium LLC in Concord, Massachusetts.” We’ve seen this repeatedly in our market surveys and analyses of published holdings data. Tabb Group gets another plug: “Almost 40 percent of money managers and insurers in a July survey by State Street and Tabb Group said they’re worried about a collateral shortage once clearing becomes mandatory for more derivatives.”
Perhaps the most telling part of the article was a quote from the US CFTC that they themselves do not know “how the collateral demands for derivatives trades will be met. Nor have they run their own analyses of risks that might be created by the banks’ bond-lending programs, people with knowledge of the matter said. Steve Adamske, a spokesman for the U.S. Commodity Futures Trading Commission, and Barbara Hagenbaugh at the Federal Reserve declined to comment.”
The biggest open question left by the story is how big could this business get. In our conversations with the reporter we were asked a couple of times for a market sizing estimate and deferred our response: there just isn’t enough “there” there to answer yet. An Oliver Wyman report cited in the article said this:
“While the $170 billion of annual revenue that securities dealers get from trading may fall by 20 percent to 40 percent once derivatives clearing becomes mandatory, “new revenues in collateral and funding are likely to offset much of those lost” from executing trades, Oliver Wyman wrote in a March report. The firm declined to estimate how much the banks might reap. Lenders and Wall Street dealers generate a combined $11 billion from clearing trades and managing collateral for clients, identified in the report as an industry growth area.” A back of the envelope analysis on this $170 billion figure means that there is no way, and we mean no way, in the current market environment that banks will make up a 20% to 40% loss in revenues with earnings from the collateral transformation trade. No way.
The big unknown at this time is what rules regulators will apply to all sorts of new collateral types. Regulators are hotly debating the Liquidity Coverage Ratio and what goes into it. Finadium reviewed the levers of these decisions in our March 2012 report, “Corporate Bonds and Equities as High Quality Assets for Collateral Management and Bank Balance Sheets.” The CCPs have been public about accepting lower quality collateral, but how low will they actually go? The lower the collateral quality, the less need for the collateral transformation trade.
The Bloomberg article is a great shot across the bow of a tough topic, and one that has and will continue to transfix the securities financing industry. But as could be expected from a fast moving, “transformational” topic, more questions are left open than answered in this piece.
Here is the Bloomberg article.
Here is our write up on the Tabb Group/State Street survey of asset managers in OTC derivatives.
Here is a listing of the many posts Securities Finance Monitor has written on the collateral transformation trade.